Managing Early Retirement Income Needs With Your Investment Properties

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Murphy’s First Law for Real Estate: Your best tenant will get a job transfer during the worst rental market of the decade.
–Murphy

I make no bones about the fact that I am a fan of investment real estate, particularly rental properties. I have nothing against flip houses; my wife and I simply don’t have the skill set to appropriately deal with them and make them profitable. I’ve arrived at my position through years of experience, and not an insignificant number of mistakes along the way.

In fact, while we have other assets to support us if necessary, our plan for ensuring we don’t get anywhere near our safe withdrawal rate in retirement is to have our living expenses (plus a buffer for budgeting errors) covered by 50% of our rental property income. We do, after all, try to live by the BiggerPockets rules when it comes to expenses and investing in real estate.

Ideally, we could simply hand the rental properties over to a multi-generational property management company, and they’d manage the properties until we rode off into the sunset.

However, at some point, we’re going to get to be too old to deal with rental properties, even in the ultra-passive mode that we’re in and we’ll want to move into safer investment instruments. This will be particularly the case as our cognitive skills decline. We’re not going to want to deal with spreadsheets, cap rates, and the like.

Plus, our property manager is about our age, and we figure she’ll want to retire in her sixties, leaving us potentially up in the air for finding property management at the quality she offers, not to mention the possibility that we won’t even be geographically co-located with our rental property portfolio by then.

To further complicate matters, while we’re in a suburb of Fort Worth, we live in a small town. The area where we have our rental properties has a total population of about 75,000. If we tried to dump a bunch of properties on the market at the same time, we’d probably flood it.

Finally, we need to consider taxes and how the taxes we have to pay will affect our decisions over time. This is particularly important because of depreciation, depreciation recapture, and the value of deferring taxes.

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What the Numbers Told Me

I built up a fairly simple portfolio of properties to assess a two-person family’s investment portfolio to examine the income and tax implications of relying on rental properties for a sole source of income while paying federal income taxes out of a separate set of liquid assets.

First, let me set up some assumptions:

  • Inflation rate of 3% per year
  • Compound average growth rate of liquid, non-real estate investments: 6% per year
  • Compound average growth rate of real estate investments: 3% per year
  • Rents increase with inflation
  • All improvements are expensed. None are capitalized. (Note: This is a simplifying assumption. I realize that if you put a new roof on a house, you’re going to increase your basis and start the roof on a new depreciation schedule)
  • All expenses except federal income tax are 50% of rent
  • Selling a house costs 8% of the total value (6% for commissions, 2% for closing costs)
  • A liquid asset safe withdrawal rate for retirement is 4%
  • Federal income tax is paid from liquid, non-real estate investments

Now, let’s look at how our couple got to the point where they felt like they could retire just using the income from their rental properties.

  • Current age of both: 45
  • They started buying one house per year in cash at age 35. The cost of the first house was $75,000 and increased by 3% each year.
  • Each rental provided $1,000 a month in income when they bought their 10th house at age 44.
  • The couple’s annual expenses, after federal income tax, at age 44 was $60,000.
  • They have $500,000 in other liquid investments.

They now own 10 houses which provided $120,000 in rental income at age 44, giving them $60,000 to live on.

Starting at age 45, they quit their jobs and live solely on the income generated from the rental properties. If they don’t sell any of the houses along the way, then their income and expenses associated with the rental properties will continue to tick along nicely.

Interestingly enough, because depreciation remains constant, until the first house has been owned for 27.5 years, at which point it decreases, while income increases, income tax and the effective tax rate on the income increases over time (Note: I have used 2013 tax rates and standard deductions and kept the same rates through the years).

Early Retirement Income Taxes and Effective Rate by Hull Financial Planning

Since this couple is taking depreciation along the way, when they sell, they will have to pay depreciation recapture taxes (currently at 25%) along with long-term capital gains taxes (currently at 15%). Thus, it is possible to calculate an after-tax and selling expense value of the real estate portfolio as well as the liquid asset investment portfolio at any given point. Since the liquid asset portfolio grows at a faster rate than the real estate portfolio, it does eventually surpass the value of the real estate portfolio.

Early Retirement Income Properties and Portfolio Value by Hull Financial Planning

At age 45, this couple would not be wise to convert their entire real estate portfolio to liquid assets despite the greater growth rate of liquid assets because of the tax advantages of rental properties. However, as they get older and the portfolio grows, they do reach a point where they could safely convert based on the safe withdrawal rate.

Early Retirement Income Asset Shortfall Over Time by Hull Financial Planning

Thus, starting at age 64, this couple could safely start converting their real estate portfolio to liquid assets without jeopardizing their ability to meet their income requirements.

A Brief Note About Social Security

Social Security is available to people who qualify for it (usually 40 quarters of sufficient earned income) starting at age 62. The more years you earn income, and the more income you earn, the more Social Security you’ll be eligible for, up to a certain point.

Social Security income may or may not be taxed depending on how much you earn in Social Security plus your earned income. Up to 85% of Social Security income could be taxable, depending on your AGI and non-taxable income.

As you start to look at a liquidation strategy, particularly if you’re planning on getting rid of some or all of your real estate around the time you’d start taking Social Security, you’ll want to be aware of how that affects the taxation of your Social Security. As of 2013, you could, depending on what you earn from other sources, pay a marginal tax rate of up to 46.25% on each dollar of Social Security that you take.

Wrapping It Up

In conclusion, it is possible to use rental properties as an income bridge to get to age 65 (or even beyond) until you can supplement your income with Social Security income. Using this strategy to protect the liquid asset portfolio that you hold should give that portion of your investments plenty of time to grow so that as you start to tap into the liquid assets when you get older, you will be well within safe withdrawal rate parameters.

About Author

Jason Hull

Jason is a Fort Worth financial advisor and creator of the Winning With Money course, a personal finance course with 20 lessons and 8 different worksheets designed to answer questions ranging from planning for your child's college to real estate to personal household budgeting. Learn more at his Fort Worth financial planner website, Hull Financial Planning. Hull Financial Planning, 2939 Crockett St. #315, Fort Worth TX 76107

13 Comments

  1. Jason Hull

    Kris–

    Yes, a 1031 exchange is certainly a possibility, particularly if you can parlay it into at least equivalent income and a chance at appreciation.

    In retirement, though, someone’s risk profile is going to change. Matching expenses with income is going to be paramount, as they don’t want to unnecessarily dip into liquid assets, and they almost certainly don’t want to have to go back to work.

    From what I’ve seen, people in their 60s are usually wanting to start to dial back their investment property portfolio – commonly citing the “I don’t want to fool with it any longer” justification – rather than rolling into new (to them) properties via 1031 exchanges. I suspect that I’m going to fall into that camp for the reasons I cited in the article.

    Then again, if leaving a portfolio to heirs is in the cards, it’s a different story due to the stepped up basis at death (at least with 2013 tax laws), but that’s also something that requires a discussion with the potential beneficiaries. I’ve picked up a couple of inherited properties that the beneficiaries didn’t want, and can say with certainty that there was potential money left on the table because of the lack of communication between the old property holder and his descendants.

  2. Jason, I’ve been in a conundrum for years. Started over at 32 and retired at 42. Now that I’m 66 would love to find something else for retirement that gives me a lot more freedom and a STEADY safe secure cash flow. Been paying zero percent in taxes for years, the thought of paying up to 46% irks me. Talked to many experts without any solutions as they can’t match my returns, told them just wanted a good cash flow. Like most people my age, don’t want to gamble on my retirement income. When the values and sales increases in my area, will to try to find a solution, hopefully.

    Your article describes me to a tee, just off by a couple of years. Great write up.

    • Jason Hull

      Hey, Jim – thanks for the kind words, and congratulations on the early retirement. You must be doing some superb income management to pay 0% taxes or you live a comfortable lifestyle that doesn’t require much income claiming. Either way, my hat is off; we do not achieve that same percentage.

      I’m sure you’ve at least thought about this, but if you’re truly most interested in income protection, have you looked at a low fee SPIA (single premium immediate annuity), perhaps dollar cost averaging into them over a period of years (given current interest rates)? It does take most of the risk off of the table, but, naturally, there’s a price for that tradeoff. There’s also evidence from a RAND Corporation study and a study of British retirees that guaranteed income (be it pension or annuity) leads to a higher level of happiness (http://www.hullfinancialplanning.com/will-annuities-make-you-happier/). It’s not a catch-all solution, but might be something for the quiver.

    • Jim,

      You retired at 42 and you want more freedom? There are only 24 hours in a day–same amount for everyone. Just kidding but not sure what you mean about wanting more freedom.

      I’d love to know just a hint about how you pay 0% taxes.

      Jason,

      You bring up a really good point about not wanting to be so involved in real estate in later years. I think I’ll have all my mental capacity for the rest of my life but in truth I’ve got some nasty diseases in my genes and I certainly may not be able to hand the management and decision making real estate requires.

  3. If it doesn’t get at least 8% return on money invested with inflation at 3% and taxes, really not worth it. According to statistics, I’m in the top 10% which is hard to believe. So far the only solution I can come up with is to sell some of my properties on a contract. Thanks!

  4. Thank you for this GREAT article Jason. I am pretty much the subject you describe here, except I turned 46 a couple weeks ago and do not yet own all of our rentals outright.

    That being said, we are closing on a duplex in 2 weeks that will put our passive income thru rentals up and over our retirement goal by almost $1K per month. Because of this, we are suddenly having to plan our transition from building a rental portfolio into how to best utilize it (and other traditional investments) to provide for us for the next 50 years!

    A Financial Planner who truly understands the marriage between traditional securities and real estate investment is invaluable… AND RARE. I look forward to checking out your website and blog to learn more.

    Jim Pratt, Congratulations!! I know the effort and discipline it takes to do what you did at such a young age. I look forward to learning more from you as well.

    • Jason Hull

      Hey, Jon–Thanks for the kind words and congratulations on the progress. It sounds like you’re awfully close to the finish line too.

      I hate to sound cynical, but a lot of financial planners are looking to sell commission-based products or don’t want you to invest in alternative investments (real estate, small business, etc.) because that takes away the amount that they can put under their management and charge you for. ‘Tis a shame.

  5. Great post, quite similar to my situation and goals.
    I hadn’t run the numbers myself, but have them in my head. Always scary to think about 20 years down the road when sitting on a much of depreciation and capital gains.
    A slippery slope, but how about a bit of leverage put into those calculations….. I like built in raises when loans are paid off.

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